amassafortune (29.54)

Derivatives, by Default, Now Treated as Senior Debt Instruments

3

The actions in Cyprus have skipped the traditional, legal method of distributing bank assets when obligations exceed assets.

Normally, shareholders and bondholders get wiped out when a business or bank entity fails. Depositors are made whole up to the limits of deposit insurance.

So why are deposits being raided in Cyprus before risk assets are touched? Because bond failures trigger derivative payouts like credit default swaps.

The derivatives market is largely unregulated. Some call it insurance, but unlike insurance, there are no capital requirements. This means there is almost no intrinsic value for derivatives to tap to pay claims. Therefore, there can be no large volume of claims without causing havoc in this market.

With the system failure of 2008 still fresh in regulator's and politician's minds, they are willing to do anything, ... anything ... to prevent a repeat.

Who holds most derivatives? Banks, or rather large banks.

After Cyprus, we have a host of smallish European countries that are in trouble. Then, significant countries like Spain, Portugal, and Italy are in trouble.

U.S. dollar assets may be OK for some years, but fleeing foreign money could prop up the dollar and thwart the Fed's attempt to prop up exports (including inflation) via a weak dollar.

If the Fed can't export inflation from easing and over-printing, they may be forced to raise rates sooner than planned or expected.

Yes, Cyprus is small, but understand the implications of what is happening.

Derivatives, by default, are now being treated as senior debt instruments.

I do not know how this will play out, but to any extent one can own their assets outright, it may be prudent to secure title. At the very least, you will give yourself a guaranteed payback at the interest rate you were paying.